Building a solid financial model requires a solid understanding of key drivers of revenues and expenses underlying the company's business model. Foresight's financial model templates are built to be used for many different business models, based on my experience in building financial models for thousands of different businesses across a multitude of revenue models. Let's unpack the meaning of business models, revenue models, and how to model common business models.
Revenue models v. Business models
Although the terms are often used interchangeably, there is a difference between a business model and a revenue model. A business model is the overall strategy behind a company - what it does, who it serves, how it is distributed, how it incurs expenses, and how it earns money - while a revenue model focuses on how value is exchanged between a business and its customers, including pricing, timing, and payment methods.
Additionally, the term revenue stream is often used interchangeably with revenue model, but there is a difference. A revenue model is a framework for how a business generates money, a revenue stream is a specific source of income within a revenue model.
A revenue model is a component of a business model, as it focuses on how a company makes money, while a business model includes the larger operational strategy behind the revenue model.
More about business models at What is a Business Model?
Modeling revenue models
From a financial modeling perspective, modeling the revenue model can mechanically be done in a few different ways:
Top-Down Forecast
A top down forecast typically starts with a macroeconomic forecast for the market a company operates in, and the uses an assumption of market share capture to calculate the company's revenues. While typically better used for estimating or justifying the addressable market size for a business, it can be used to forecast revenues in the absence of past data and to provide a "check" on more detailed bottoms-up forecasts. All too often, a company builds a detailed bottoms-up forecast based on forecasting customer acquisition and retention, but fails to check to make sure that the implied percentage of the addressable market captured is reasonable. But the issue with depending on this as a primary forecast method is that it gives no insights into the operational drivers of growth and thus is not useful for making tactical deecisions about the business.
Another tops-down way to forecast revenues is to start with the previous period's revenues and apply an assumed growth rate to calculate the current and future revenues. If the business is mature, the past is an indicator of the future, and you have historical data to use, this can be a good starting point to forecasting a business. Like a top-down forecast, this method does not capture key operational decisions to understand "why" a business is growing, and if you are forecasting an immature business with limited historical data, this method suffers from the same resulting issues.
Bottoms-Up Forecast
This method involves building up a forecast based on the building blocks relevant for the company at that stage in time. Often this is based onmodeling customer-focused operational components of the business model, including:
- Growth - how the business generates new potential customers (marketing channels, sales channels, etc.)
- Conversion - how the business converts them into new customers (trials, contracts, etc.)
- Retention - how the business retains customers (customer support, product updates, etc.)
- Revenues - how the business generates revenue from customers (including pricing, timing, payment methods, etc.)
The methods to forecast growth could include:
- A sales capacity (or quota capacity) forecast for a sales-driven business, which forecasts the hiring of new sales people, their sales ramp (the time it takes to become fully productive), and their lead generation success or sales quota to forecast the number of new customers acquired per period.
- A marketing channel forecast for marketing-driven business, which forecasts marketing spend, new leads, new customers, or some operational growth metric for the business.
- A product-led growth forecast for product-drive companies, which may focus on activating, engaging, and retaining customers through their interactions with the product. Customer acquisition is driven by inbound strategies to drive trials or free users, converting and retaining them to paid users, and building sharing and virality into how customers use the product to create a cycle of growth where the product itself is the primary driver of growth.
Modeling a company's complete business model could encompass a mixture of all of these methods, and could be split up by business segments, customer segments, product features, or any level of grouping that can help deaverage a business and help build a better forecast.
Modeling business models
A business model may consist of multiple revenue models, depending on how the business creates value for users and how the business chooses to monetize that value. In addition, modeling a business model often includes:
- Variable expenses - how the business incurs expenses that are variable based on growth and retention of customers (for example, marketing expenses)
- Fixed expenses - how the business incurs expenses that are fixed regardless of growth or retention of customers
- Semi-fixed expenses - how the business incurs expenses that are fixed over some time period or some number of customers, but will change, often in step changes, as the number of customers changes (for example, a hiring plan or rent)
- Cash flows - how the expenses are paid and how the business collects cash for earned revenues (for example, the timing of those payments)
Modeling revenues and expenses is the core part of building a financial model for a business, and everything else - financial statements, key performance indicators, and more - are ways to view and analyze the performance of the business based on (a) the accounting rules the business is subject to and (b) the metrics, key drivers, and benchmarks for that specific business model.
A common tool used to visualize, communicate, and design business models is the business model canvas, which breaks down business model into nine primary components for strategic analysis and exploration.
FP&A models
Financial Planning and Analysis (FP&A) models encompass a wide range of financial models to support business decision making and strategic planning. They include the core aspects of revenue models and business models detailed above, but may include any analysis to understand the past, present, and future performance of a business.
Mosaic's post on FP&A Modeling: 8 Models for Financial Forecasting is helpful for understanding different models in FP&A and includes a few examples of modeling revenue models and business models.
Common revenue models
Below are are a list of a few common revenue models with considerations about how to model the revenue model and their related operational and expense components.
Subscription
Subscription is a common revenue model where customers (or subscribers) pay a recurring fee for access to a product or service. The fee could be be paid monthly, annually, or some other time period, and the services or products delivered on a recurring (most typically available at all times each month) basis. Companies will often create different subscription tiers to target the features, functionality, access, or pricing to different customer segments. Software-as-a-service (SaaS) is a common business model for software companies leveraging a subscription revenue model. Subscription revenue models can often be used for physical products as well, such as subscription boxes, where the customer pays a monthly fee to get a new set of products each month.
Key components to modeling a subscription revenue model include:
- Acquisition of new customers. This may be based on marketing spend, outbound sales, partnerships, and many other acquisition channels and methods a company decides to use. Simple approaches will just model the total new customers acquired per period, other approaches will model the growth activity and it's conversion into new customers, and more complex methods will model each acquisition channel separately and may even model retention and revenues per original acquisition channel.
- Retention and Churn. At every point where the customer's contract is up for renewal, the business must model the likelihood of the customer renewing or ending their subscription. Churn reflects customers ending their subscriptions, and there are multiple ways to model churn; many companies will model churn as a percentage of the total number of customers at the beginning of the period, while others will look to model the churn of customers who have been with the business for a certain period of time. The difference is that the latter approach requires a time-based cohort approach, which is more complicated, but can better reflect churn if the expectation of churn changes over a customer's lifetime.
- Bookings, Billings and Recognized Revenues. The concept of revenues is often misunderstood. The total value of a customer's contract when a new contract is signed (bookings), when customers are billed (billings), and when revenues are recognized (recognized revenues) may be different if the contract lengths are greater than one month and the amount paid upfront is greater than one month's revenues. Billings reflects when the customer is billed, and recognized revenues reflects when the business delivers the service or product and recognizes the revenues on the income statement. New billings each period are added to deferred revenue, which is reduced by the amount of recognized revenues each period. Note, billings does not represent cash received, as the timing of payments may be different from when the customer is billed.
Modeling the related operational components of a subscription revenue model requires modeling the costs necessary to deliver the product or service. This could include product and material costs related to the products delivered that period, shipping, fulfillment, customer support or customer success costs, hosting, and more.
Software-as-a-Service
The complexities in modeling SaaS businesses often come down to defining the customer segments and pricing tiers to model. If the company has different pricing tiers, some companies may choose to model each pricing tier separately, while others will just model the total number of subscribers using a weighted-average revenue per customer approach. The two approaches can be equivalent if you assume the same growth rates of customers in each pricing tier, and you can still break out the revenue contribution by pricing tier even if you use a weighted-average approach. But some will prefer the granularity of modeling each pricing tier separately if they want to make different growth, retention, or changes in pricing or revenues per period.
In addition, Software-as-a-Service (SaaS) businesses are often best modeled using a time-based cohort approach to model the acquisition and retention of customers over time, allowing you to model a retention curve that changes as a customer ages (e.g. high churn early in a lifetime, lower churn as a customer's total time with the business increases). Meaning, instead of just using one retention curve to apply to all customers, you model the retention of each monthly cohort of new customers separately (usually each cohort is in it's own row), and sum up the total of all the cohorts to get the total number of customers at the end of each period. The detail in a cohort approach allows a modeler for more flexibility and granularity in modeling:
A. Use a retention curve that reflect changing retention per period related to how long a customer has been a subscriber
B. Use a revenue curve that may reflect changing revenues per customer per cohort, either to reflect grandfathered plans, land and expand strategies (revenue increases as a customer grows their business, usage, seats, etc.), upgrades to larger pricing tiers, changes in the mix of pricing tiers offered (if using a weighted-average approach to modeling multiple tiers), and other per-cohort revenue adjustments.
There are innumerable places on the web to learn more about SaaS businesses, I suggest starting with The SaaS CFO as a good resource for the topics that matter.
Product-as-a-Service
The Product-as-a-Service model (PaaS), also known as Product Service Systems, is a business model where a company bundles services with products. PaaS can usually be modeled using the same mechanics as a subscription revenue model.
There are also a few revenue models that are not considered subscription revenue models, but can be modeled using the same or similar methods.
Pay-per-seat
Pay per seat is a revenue model where a customer pays a recurring fee based on the number of users ("seats") they have in their organization. Modeling pay-per-seat is very similar to subscription revenue models, and the number of seats can either be an explicit part of the revenue calculations (e.g. organizations * seats * price per seat) or an implicit part of the revenue calculations (e.g. organizations * price per organization).
Usage-based
Usage-based (or consumption) business models charge customers based on how much they use a product or services. Usage is monitored and billed on set time periods or based on usage limits per period. Usage-based business models can often be modeled using subscription revenue methods by calculating the average usage per period and the revenues per use to determine the average revenue per customer per period, and either using that for all customers or dividing the customers up into different segments or groups based on typical usage. The variation in monthly spend creates issues in reporting and forecasting, but subscription mechanics are still a good base for usage-based business models.
Royalties
Royalties are often a subset of usage-based business models, where a distributor of a product will pay fees to the creator or owner of the product based on customer usage. Many royalty business models can be modeled with the same mechanics as usage-based business models.
Advertising
Advertising-supported business models earn revenues from advertisers who pay to have their ads displayed to the company's users. Advertising revenue models can be modeled by using a demand-driven approach (number of advertisers, average price paid per advertisement), a supply-based approach (number of users, number of impressions, advertisements per impression, number of advertisements sold per impression or fill rate, price per ad), or a subscription-like approach (number of active users, advertising revenue per active user per period). Regardless of the modeling technique used, businesses will often simplify their understanding of the business down to users and revenues with metrics like advertising revenue per user (ARPU). The right approach will vary by the business and its needs at that point in time.
Renting and Leasing
Renting (providing access to physical products, spaces, or fixed assets for periods up to a year) and leasing (typically longer-term contracts) business model scan also be modeled using the same mechanics as subscription revenue models, although often with different terminologies. Modeling licensing and renting can also involve more detailed accounting treatment of revenues and expenses, including amortization and deprecation of the assets being rented or leased.
Freemium
Freemium is often described as a subscription revenue model, but it's actually an acquisition model. Freemium involves giving users access to a free version of the product or service and selling them access to premium features. The mechanics to modeling freemium businesses are the same as subscription revenue models, just noting that it is important to model the acquisition and retention of free users, their conversion to paid users, and the costs to providing the product or service to all users (not just the paid users).
Product-led Growth
Product-led Growth (PLG) refers to an acquisition strategy that is based on leveraging product mechanics for outbound and inbound customer acquisition. This may lean on tactics to create virality or sharing of the byproducts of customer usage of the product or service. PLG doesn't define a revenue model, but it does indicate a focus on what a company is allocating resources to, and a company must treat it as a component of it's business model in order to succeed.
Licensing
Licensing is a business model that often uses a subscription revenue model, where the customer pays a recurring fee for access to a product or service, but can also use a transactional revenue model where the customer pays a one-time fee for unlimited access for a particular time, or a one-time fee for a specific use, or a one-time fee for perpetual use, or other variations. Licensing is often used for intellectual property, trademarks, patents, among other types of products, and can also be used by software companies one-time sales of licenses for products.
There are many different ways to model a subscription revenue model, and the right approach will depend on the stage of the business, the complexity necessary to model at that time, and the key questions for stakeholders and potential investors to address.
Transaction
A transaction revenue model is where a customer pays a one-time fee to get a product or service in return. Many different types of business models leverage a transaction revenue model, including manufacturers, marketplaces, retail (both physical and ecommerce), wholesalers, affiliates, reselling, agency, brokerage, services, and more. A transaction-based revenue model is also related to other types of revenue models, such as donations, commissions, and more, and can come under names like markups, cost-plus, or other variations.
Key components to modeling a transaction revenue model include:
- Transactions per period. This may be done by modeling customers, orders, or whatever the transaction is called, but the key is to model the level of transaction activity per period
- Average transaction value or average order value (AOV). This will reflect the gross merchandise value (GMV) or average order value (AOV) or some other metric that captures the average monetary value of a transaction.
- Gross transaction value (GT) or gross merchandise value (GMV). This is the total value of all transactions in a period.
- Revenues. This may be equal to gross transaction value if the business is selling something they made or purchased, or it may be a percentage of gross transaction value if they are operating a marketplace or other business model where they are facilitating transactions.
Ecommerce
Ecommerce is a common business model for companies selling physical or digital products that uses a transactional revenue model. Companies produce goods that they sell to consumers, primarily using the internet to acquire customers, without requiring customers to step into a physical store to make a purchase.
Modeling ecommerce businesses can be straightforward or complex, depending on the number of SKUs, warehouses, inventory management, materials purchasing, marketing channels, repeat customer behavior, and other factors, and one of the key things for a business to decide is what level of detail is valuable for forecasting and operating the business. I typically model ecommerce businesses using a time-based cohort approach to model new and repeat customers and calculate revenues as total orders multipled by average order value, or when available or applicable layer a cohort-based approach for the average order value or average transaction value of repeat purchases to then calculate revenues.
A key component to modeling ecommerce businesses is modeling inventory management and the cash flows associated with purchasing materials or inventory. More details on how to model inventory at Inventory.
Marketplace
A marketplace business model is one where the business brings together buyers and sellers and faciliates transactions between them. Marketplaces may charge fees to buyers and/or sellers, they may charge subscription fees to sell or buy, they may charge transaction fees on a fixed or semi-fixed amount per transaction or number of transactions per period, or transaction fees as a percentage of the transaction amount.
Modeling a marketplace business model often utilizes a mix of subscription and transactional revenue models, and is fundamentally based on modeling the supply-side (sellers) and demand-side (buyers) of the marketplace and the resulting transactions the marketplace facilitates.
Services
A services, consulting, or professional services business model is where the business provides a service to customers and charges a fee for the service. The services could be one-time or recurring over a period of time (a services contract, a consulting agreement, a project, a retainer, etc.), and priced as a one-time, recurring, or the contact culd specify a payment schedule (e.g. a percentage upfront, percentage upon completion or end of contract).
Modeling a services business model can be harder because of the variations in the ways people forecast services businesses from a project and staffing perspective. You could model the number of projects, revenues, hours and staffing required per project, and create a staffing plan combining employees and contractors necessary to deliver the projects. You could also model the employees, their salaries, billing rates, and utilization per period to calculate revenues and costs. A demand-drivern forecast (projects) is usually a better approach because it forces one to think about how to drive projects and growth, but both approaches can work.
Financial
Financial services firms often work a bit differently than other businesses. This is not exhaustive, but a summary a few common revenue models in this area.
Interest
In its simplest form, an interest revenue model is where a business loans money to a customer and charges interest on the loan, which ia paid through a monthly loan payment comprised of principal and interest. Their costs are typically the cost of funds, meaning the expenses they pay on the money they lend out. A common revenue model for commercial banks, they accept deposits from customers and lend out money to individuals and businesses.
Trading
Trading is a revenue model where a business buys and sells financial instruments, such as stocks, bonds, currencies, commodities, and more, and earns a profit from the difference in the price of the instrument when it is bought and sold. Businessess may do this with their own capital, or they may do it on the behalf of customers, charging subscription fees, a percentage of the assets managed, a percentage of the profits from trading, or other variations. Trades may be short-term (e.g. public equities, futures, options) or long-term (e.g. private equity, venture capital). Trading may also involve an arbitrage strategy, where the business buys and sells the same asset in different markets to profit from the difference in price.
Modeling trading revenues models is typically similar to transactional revenue models, where you have to calculate the cost of the assets bought, and the proceeds from selling the assets, and the total value of the assets held by the business, and then from that you can calculate the revenues depending on which specific revenue stream the business is using.
Insurance
Insurance is a revenue model where a business sells insurance policies to customers, and in exchange for a premium, the business agrees to pay for losses that the customer may incur. The revenues to the business are the regular premium payments from the customers.
Modeling an insurance revenue model is similar to a subscription revenue model, calculating the acquisition and retention of customers and the regular premium payments. The payments to customers when they incur losses is an expense, and the business must model the liklihood of the timing and amount of those losses to forecast the projected expenses and cash flows.
Summary
Modeling a business model can be hard, and it can be confusing to sort through the different types of revenue models and the pricing schemes that are used. Suggestions on business or revenue models to add above, or questions on modeling your business, ask anytime.